A framework for pricing decisions: key inputs - Marketing Management

The starting point for developing a pricing structure is the delineation of a framework for pricing decisions. Specifically, we need to establish key inputs to pricing decisions. Although there are a myriad of considerations for arriving at a price for a product or service, the following are considered to be key inputs for the pricing decision maker that are now discussed:

company and marketing objectives;

demand considerations;

cost considerations;

competitor considerations.

Company and marketing objectives

Pricing decisions are salient to the achievement of corporate and marketing objectives, so it is essential that pricing objectives and strategies are consistent with and supportive of these objectives. Oxenfeld, illustrates both the potential range of pricing objectives and their clear relationship to overall corporate and marketing objectives.

This selection from an even wider range of possible pricing objectives which Oxenfeldt1 delineates, illustrates the fact that the pricing decision maker must establish what objectives the pricing strategy is to achieve. The continued link between corporate objectives and pricing strategies is confirmed in a more recent studies by Kehagias et al.2 and Indounas and Avlonitis.3 We can also see that according to the precise objectives, we might arrive at very different prices for our product and services.

Where a company has multiple objectives, pricing strategies may need to consider tradeoffs between different possible price levels, such that these different objectives are met. In addition to these broader corporate objectives, pricing decisions must also reflect and support specific marketing strategies. In particular, pricing strategies need to be in line with market targeting and positioning strategies. Clearly, if a company produces a high quality product or service aimed at the prestige end of the market, it would not be sensible to set a low price even if cost efficiency allowed this. Pricing, therefore, must be consistent with the other elements of the marketing mix and the selected positioning strategy.

Effectively, the selection of company and market objectives, market targets and the formulation of a positioning strategy constrains or delineate the range of pricing strategies and specific price levels. An example of how price must reflect and support the overall positioning strategy of the company is the price set for the Aston Martin DBS. The car is positioned at the top end of the market and with just 500 made in the UK for sales worldwide the emphasis is on exclusivity. Many people still associate Aston Martin with the James Bond character, 007, again emphasizing the racy and prestigious image intended. Prices start at £160,000.

Pricing and corporate/marketing objectives

Demand considerations

A key parameter affecting pricing decisions is customer based. The upper limit to the price to be charged is set by the market, unless the customer must purchase the product and we are the sole supplier. In competitive markets, demand, i.e. the price customers are willing and able to pay, is a major consideration in the selection of pricing strategies and levels. It is in analysis and interpretation of demand and demand schedules that the economist has much to offer the marketer in terms of concepts and techniques.

Ideally, the marketing manager needs to know the demand schedule for products and services to be priced. The demand schedule relates prices to quantities demanded and can be illustrated by the use of a diagram.

The demand curves The number of units that can be sold at any given price. In addition, the slope of the demand curve is directly related to the price sensitivity of demand. Demand curve D1 slopes less steeply than D2 where demand is more price-sensitive. Even simple demand curves represent powerful tools for pricing decision makers, showing, as they do, both the number of units that can be sold at any given price and the effect on this quantity of any changes in price. However, price is only one of the determinants of the demand for a product or service. In addition to price the following represent some additional factors which combine to determine demand:

income/budget of the purchaser;

attributes of the product;

tastes of the purchaser;

price of other products;

the time it takes to deliver.

Examples of simple demand curves

Although the views put forward by economists are sometimes difficult to envisage in reality, they are useful in terms of being able to relate to in marketing terms because these theoretical positions tend to relate to certain kinds of marketing behaviour. With this background in mind, an industry or service provision that more or less equates to perfect competition, oligopoly and monopoly is:

perfect competition – the restaurant trade;

oligopoly – motor cars; petrol

monopoly – the electricity generating industry.

At price P the law of demand states that quantity Q will be demanded. If the price is then reduced to P1, then Q1 will be demanded, so Q–Q1 will be the additional amount demanded. However, in a situation of oligopoly where price as an instrument of competition is less effective, then the demand curve will kink to D1 and the dark area covered by Q–Q2 will be the additional amount demanded. A price reduction in these circumstances is less effective as customers will have been ‘pre-sold’ their existing products through non-price factors like advertising and branding; this is termed ‘non-price competition’.

Income/budget of the purchaser

The ability of the purchaser to buy products and services according to individual income level and purchasing power converts the purchaser’s needs and wants into actual purchasing. The economist refers to this willingness to purchase as ‘effective demand’. For an organizational buyer, the ability to purchase is directly related to budget requirements and constraints set on the purchaser.

Oligopoly

Attributes of the product

Demand for a product or service and the price the customer is willing to pay, is related to the attributes of competitive products being offered. Demand for a product is closely related to how the customer perceives the various attributes of competitive products. These attributes include physical/tangible attributes e.g. quality features and packaging, and ‘non-tangible’ attributes, such as brand/corporate image and status.

Tastes of the buyer

Related to attributes, another factor affecting demand is the tastes of the buyer. Although a somewhat nebulous concept, ‘tastes’ are a powerful influence on demand. Changes in taste can give rise to the growth of entirely new markets and the demise of mature ones.

The growth in popularity of hybrid powered cars over recent years is an illustration of changes in taste. However, their demise might be just as rapid as a result of negative publicity surrounding their use e.g. the relatively short range and difficulties of recharging vehicles. ‘Tastes’ can be of an industrial nature such as being associated with variables like emphasis on productivity improvements, quality management and employee care and protection.

Price of other products

The price of competitive products is a key area affecting demand. Inevitably buyers tend to consider prices of substitute products when evaluating the effect of prices on demand. However, if the consumer has to spend more disposable income on essential items due to increases in the prices of these items, e.g. food and mortgage repayments, then the consumer’s disposable income demand for other apparently unrelated products can be affected. Clearly, in the case of substitute products, how the price of one item compares to the price of another is central to the selection process of the buyer. In the current recessionary climate this is of heightened relevance as witnessed by increased numbers of price comparison websites.

The time factor

When discussing demand for a product or service, we must consider the time factor, i.e. demand must be specified for a given time period. For example, it is conventional to distinguish between ‘short’, ‘medium’ and ‘long run’ time horizons when discussing demand. Demand can vary over these different time periods. The time period must be explicit when evaluating demand concepts in the context of marketing.

From the perspective of the pricing decision maker, it is essential to assess sensitivity of demand. From discussion of the slopes of the demand curves, the slope of the demand curve indicates what the effect on quantity demanded will be for any given change in price. This effect is referred to as the price elasticity of demand.

Elasticity of demand

Price elasticity of demand means demand for a product is inelastic if consumers will pay almost any price for the product and very elastic if consumers will only pay within a narrow band of prices. Inelastic demand means a producer can raise prices without affecting demand too much, and elastic demand means consumers are price sensitive and will not buy if prices rise too much. A medical cure that will save a person’s life has inelastic characteristics in that the person whose life is at risk will pay anything for the cure, so price is inelastic. However, demand for cars is elastic because if prices rise too much consumers will switch to alternatives like shared lifts or public transport or car hire.

Elasticity can be expressed by:

E =

% change in quantity demanded% change in any demand determinant

The demand for a product to be responsive, or not, to changes in price can be summarized as a function of:

the number and closeness of substitutes;

the necessity of the purchase to the buyer;

the importance of product performance to the buyer;

the cost of switching suppliers.

The number and closeness of substitutes

Of all determinants of price elasticity of demand, this is probably the most important. If the product is in competition with a number of others that are similar in quality, perform similar functions and are being offered at a lower price, then it follows that demand for the lower priced product will be greater.

The marketer can modify price-sensitivity of demand for the company’s products and services by differentiating them from those of competitors. For example, the market can be ‘desensitized’ to differences in price by, say, better quality or improved packaging. Unless a company is in a position to compete and win purely on price, every effort should be made to gain a competitive edge by differentiating products from close substitutes.

The market for detergents and cleaning products such as washing powders, washing up liquids and bleaches is extremely competitive. To avoid competing purely on price, companies have made substantial efforts to differentiate their brands from those of competitors. An example of a brand successfully differentiated from its competitors is Fairy Liquid.

For many years Fairy Liquid successfully based its differentiation on its ‘kindness’ to the hands of the user. When other brands began to blur this differentiation through their marketing efforts, introducing their own claims for gentleness in use, Fairy Liquid switched the differentiation to one of the brand being both long established and more effective and, by implication, better value for money compared to its competitors.

The necessity of the purchase

Some product categories are essential purchases for the consumer, whereas others can be classified as luxuries. For example, food, water and electricity are ‘essentials’. Total market demand for products and services in this category tends to be less sensitive to changes in price than products and services we count as luxuries. We should note though that individual products and brands, even within the ‘necessities’ category, can be extremely price-sensitive where there are available substitutes. In addition we should note that what is a ‘luxury’ for one consumer may be a ‘necessity’ (or utility good) for another, depending on disposable income, attitudes and lifestyles.

For example, many of us only buy flowers for special occasions and even then might balk at paying more than say £40. In 2009, French President, Nicolas Sarkozy and his wife Carla Bruni were reported as spending over £660 per day on flowers.

The importance of product performance

In certain industrial markets, where the buyer is primarily concerned with performance specifications, demand will tend to be inelastic with regard to price. If a situation arises where the product fails and the buyer would suffer severe penalties in the form of cost, production time or convenience, then demand would be inelastic to price.

Cost of switching suppliers

Hutt and Speh4 have pointed to the importance of ‘switching costs’ in industrial markets. For example, in some situations an industrial user of a component part may align certain part specifications of its products to that of the supplier. The firm may have also made a heavy investment in tooling charges or in installing a supplier’s equipment, e.g. a dedicated computer system. The cost here of turning to another supplier would probably be prohibitive and not in the best interests of the purchasing organization.

Cross elasticity of demand

As far as demand is concerned, products can be related in any one of a number of ways. First, they may be competing products or substitutes, in which case, an increase in the purchase of one product may result in a decrease in the demand of another. Next, when products are of a complementary nature, an increase in demand for one product may result in an increase in demand for another. Finally, when two products are of an independent nature then a purchase of one product will have no effect on the demand of another. Cross elasticity of demand is a measure for interpreting the relationship between products. It measures the percentage change in the quantity demanded of a product to a percentage change in the price of another product, shown by:

Sxy =

% change in quantity of y% change in price of x

Possible shapes of demand curves

Marketers need to be aware of the way customers react to a given price level, which in turn is related to the shape of the demand curve, In fact there are a number of possible shapes for demand curves. Each curve illustrates sets of customers reacting to a change in price by plotting the price of the product against the level of sales. In plotting these curves, all other factors are kept constant in line with the assumptions of the microeconomic theory of pricing. A variety of possible shapes for demand curves.

A traditional economic demand curve. Assuming ‘rationality’ on the part of consumers, the lower the price, the higher the quantity demanded. The majority of markets are characterized by this shape of demand curve.

A frequently encountered demand curve, though one that is often not appreciated by pricing decision makers who use traditional economic principles. Here, lowering the price of a product increases demand up to a point, but below this threshold, the desirability of the product, and hence demand, decreases due to suspicion of ‘poor quality’ signalled by the lower prices. Such suspicions may or may not be justified, but it is customer perceptions that count. A market where regardless of price charged, demand remains unchanged. This seemingly ‘unrealistic’ market situation is a characteristic of markets where the customer must purchase the product and where there is only one supplier of that product i.e. a monopolistic situation.

A market where increased prices result in increases in demand. Markets where this might occur are those where the consumer is eager to signal that the product is affordable with the higher price being an indicator of the prestige and status of the buyer. An example here is well known brands of perfume.

An understanding of price/volume relationships is crucial to pricing decision making. In practice, particularly for new products, estimating these relationships can be difficult. It is essential in analysing demand to examine the buyer’s ‘perception of value’ as the key to demand and pricing decisions; a factor we return to later.